7 facts you need to know before investing in cryptocurrencies

Is bitcoin confusing to you? Here's what you need to consider.

Cryptocurrency, also known as virtual currency or digital currency, took the world by lightning storm in 2017.

Like real currencies, cryptocurrencies allow their owners to buy goods and services. However, much of the interest so far in these unregulated currencies is to trade them for profit, with speculators driving prices skyward.

More speculators seem to be piling in every day. In 2017, according to Business Insider, new cryptocurrencies raised more than $3.5 billion in initial coin offerings. An ICO is a type of fundraising similar to the initial public offerings of stock, in which the public is allowed to buy coins in the offering. Things only got hotter as 2017 progressed, and the ICO market remains red hot in 2018.

Here are seven things to ask about cryptocurrency, and what to watch out for.

1. What Is Cryptocurrency?

Cryptocurrency is a form of payment that can be exchanged online for goods and services. Many companies have issued their own currencies, often called tokens, and these can be traded specifically for the good or service that the company provides. Think of them as you would arcade tokens or casino chips. You’ll need to exchange real currency for the cryptocurrency to access the good or service.

Cryptocurrencies work using a technology called blockchain. Blockchain is a decentralized technology spread across many computers that manages and records transactions. Part of the appeal of this technology is its security.

2. How Many Are Out There, And What Are They Worth?

As of January 2018, about 1,400 cryptocurrencies were trading hands, and they continue to proliferate, raising money through initial coin offerings. By the first week of December 2017, ICOs had raised $1.38 billion in the fourth quarter, on top of the third quarter’s $1.74 billion, according to research conducted by Token Report. And both dwarf the approximately $100 million ICO haul in 2016.

But this new fundraising doesn’t include the value of longer-lived currencies such as bitcoin and ethereum that have already gone public. As of Jan. 5, 2018, the total value of all bitcoins, the most popular digital currency, was pegged at $283 billion. The second-most popular, called ripple, was valued at $119 billion. The total value of all cryptocurrencies is about $708 billion, according to Coin Market Cap.

3. Why Are They So Popular?

Cryptocurrencies appeal to their supporters for a variety of reasons. Here are some of the most popular:

Supporters see cryptocurrencies such as bitcoin as the currency of the future and are racing to buy them now before they become more widespread and presumably more valuable

Some supporters like the fact that cryptocurrency removes central banks from managing the money supply, since over time these banks tend to reduce the value of money via inflation

Other supporters like the technology behind cryptocurrencies, the blockchain, because it’s a decentralized processing and recording system and can be more secure than traditional payment systems

Still others like the anonymity of the blockchain network, which allows for transactions outside government surveillance, including criminal activities

Some speculators like cryptocurrencies because they’re going up in value and have no interest in the currencies’ long-term acceptance as a way to move money

4. Are They A Good Investment?

Cryptocurrencies may go up in value, but many investors see them as mere speculations, not real investments. The reason? Just like real currencies, cryptocurrencies generate no cash flow, so for you to profit someone has to pay more for the currency than you did. That’s what’s called “the greater fool” theory of investment. Contrast that to a well-managed business, which increases its value over time by growing the profitability and cash flow of the operation.

As NerdWallet writers noted in a recent discussion, cryptocurrencies such as bitcoin may not be that safe, and some notable voices in the investment community have advised would-be investors to steer clear of them. Of particular note, legendary investor Warren Buffett compared bitcoin to paper checks: “It’s a very effective way of transmitting money and you can do it anonymously and all that. A check is a way of transmitting money too. Are checks worth a whole lot of money? Just because they can transmit money?” And the CEO of megabank JPMorgan Chase, Jamie Dimon, called bitcoin a “fraud.”

For those who see cryptocurrencies such as bitcoin as the currency of the future, it should be noted that a currency needs stability so that merchants and consumers can determine what a fair price is for goods. Bitcoin and ethereum have been anything but stable in 2017, and through much of their history. For example, at the start of 2013 a bitcoin traded for $13.50, while in January 2018, it changes hands for around $16,000. And ethereum was even more volatile in 2017. That leads some investors to think you should be petrified of bitcoin and other cryptocurrencies.

This price volatility creates a conundrum. If bitcoins might be worth a lot more in the future, people are less likely to spend and circulate them today, making them less viable as a currency. Why spend a bitcoin when it could be worth three times the value next year?

5. How Do You Buy Cryptocurrency?

To obtain some of this cryptocurrency — there are many issued by many different companies — users often must exchange bitcoin or ethereum. To buy either of these cryptocurrencies, you’ll need a “bitcoin wallet,” an online app that can hold your currency. You register with your identity and bank details, then you can transfer real money to buy cryptocurrencies such as bitcoin or ethereum.

But you don’t have to buy them directly. Some investment companies have created bitcoin exchange-traded funds, and more are being designed, so investors could purchase a fund that holds bitcoin, much the way they would buy and sell stocks or funds. This would be a relatively simple way to access the currency, and you’d likely be able to trade through your existing broker. But don’t hold your breath on an explosion of ETFs. The Securities and Exchange Commission has been slow to approve bitcoin-based ETFs.

There’s a new third option, introduced in December 2017. Investors can now buy and sell bitcoin futures, allowing you to buy or sell bitcoin at a specified future date for a predetermined price. If you go this route, you’ll want to read up on futures trading and how to get started.

6. Are Cryptocurrencies Legal?

There’s no question that they’re legal in the United States, though China has outlawed their use, and ultimately whether they’re legal depends on each individual country. Also be sure to consider how to protect yourself from fraudsters who see cryptocurrencies as an opportunity to bilk investors.

The SEC has been increasing its regulation of coin offerings and cryptocurrencies generally. That’s good news for investors, since this will help to weed out fraud and protect investors. But as always, buyer beware.

7. How Do You Protect Yourself?

If you’re looking to buy a cryptocurrency in an ICO, read the fine print in the company’s prospectus for this information:

Who owns the company? An identifiable and well-known owner is a positive sign.

Are there other major investors who are investing in it? It’s a good sign if other well-known investors want a piece of the currency.

Will you own a stake in the company or just currency or tokens? This distinction is important. Owning a stake means you get to participate in its earnings (you’re an owner), while buying tokens simply means you’re entitled to use them, like chips in a casino.

Is the currency already developed, or is the company looking to raise money to develop it? The further along the product, the less risky it is.

It can take a lot of work to comb through a prospectus; the more detail it has, the better your chances it’s legitimate. But even legitimacy doesn’t mean the currency will succeed. That’s an entirely separate question, and that requires a lot of market savvy.

But beyond those concerns, just having cryptocurrency exposes you to the risk of theft, as hackers try to penetrate the computer networks that maintain your assets. One high-profile exchange declared bankruptcy in 2014 after hackers stole hundreds of millions of dollars in bitcoins. Those aren’t typical risks for investing in stocks and funds on major U.S. exchanges.

Written by James Royal for NerdWallet. James Royal, Ph.D. is a writer at NerdWallet. Email: [email protected] Twitter: @JimRoyalPhD.

The article Cryptocurrency for Beginners: 7 Questions to Ask originally appeared on NerdWallet.

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